A major company in Chile had outsourcing service contracts and equipment rentals with an annual expenditure exceeding $20 million, achieved through competitive bidding processes. When the time came to renew these contracts, we proposed an alternative approach instead of the usual bidding process. By applying the “Should Cost” methodology, we helped identify a reduction of over 30% in total costs and capture much of this savings through demand review and price negotiation.
One might assume that in a competitive market with multiple suppliers, a bidding process should secure the best price for the buyer. However, applying the Should Cost methodology enhances both the definition of needs and the final price, significantly impacting the company’s total cost.
In this article, we explain how it works and share our successful experience.
What is the “Should Cost” Methodology?
The “Should Cost” methodology is an analytical approach used to estimate the cost that a product or service should have, considering all cost components, from materials and labor to indirect costs. This approach not only helps companies identify areas for cost savings but also provides a solid foundation for supplier negotiations.
To effectively implement the “Should Cost” methodology, it is crucial to focus on two key components: cost breakdown and benchmarking. Cost breakdown ensures that all elements impacting the final price are considered, while benchmarking allows for a comparison with market standards, ensuring competitiveness and efficiency.
How is Cost Breakdown Performed?
A detailed cost breakdown is essential for an accurate estimate. It is crucial to consider all costs involved, including materials, labor, indirect costs such as overhead and office expenses, and any other expenses incurred by the supplier. For labor, it is important to go beyond the base salary and calculate the full employer cost, including benefits, insurance, and other labor-related expenses. Additionally, a reasonable profit margin for suppliers should be included, ensuring a win-win approach that fosters sustainable and fair relationships.
What Benchmarking is Needed for an Effective Should Cost Analysis?
Effective benchmarking involves finding comparable industry references for each cost item. For salaries, market studies that show industry salary ranges are recommended. For materials and machinery, real supplier quotations provide the most reliable basis for comparison. It is crucial to include all associated costs, such as financing costs, to gain a complete and realistic view of comparative costs.
In one of our recent projects, we analyzed heavy machinery rental for a mining operation. After conducting a detailed Should Cost analysis, an open bidding process was held, with more than ten bidders participating. Using the “Should Cost” analysis as a baseline, we supported the contracts team in reviewing each offer in detail and then negotiating.
We found that one of the biggest differences among bidders was related to the financing rate and the residual value of the machinery used. These factors are usually not explicitly stated in the offers, but because we had a thorough market cost analysis, we identified that these categories were the main cost differentiators. Thanks to this insight, the contract negotiation process was smoother, as it focused on these two key points. Suppliers were able to adjust their assumptions to submit the best possible offer, ensuring a mutually beneficial outcome. The result was a cost reduction of approximately 15% between the initial and final offers.
The “Should Cost” methodology is one of the many strategic sourcing tools we use at Montblanc to help companies accurately and fairly estimate production costs, providing a strong foundation for supplier negotiations and cost optimization.
The principles outlined here can also be applied to developing a zero-based budget, enabling companies to seek cost improvements beyond supplier negotiations. This methodology not only optimizes costs in existing contracts but also provides a solid foundation for financial planning and resource management across the organization.